Eye on the Market I October 15, 2012

Eye on the Market I October 15, 2012 J.P.Morgan Topics of the week: the slight upturn in US leading indicators and the implications for profits; the magnitude of the US housing recovery; Europe's prize; and US energy independence We are working on our annual energy issue, which will come out next week. In the meantime, topics that True Believers have written about that we found interesting: assertions that recent improvement in leading indicators heralds better things ahead for the global economy and for profits; an article by Roger Altman arguing that the US housing recovery will contribute to a robust US expansion next year; the belief that the US can become energy independent within 10-15 years; and the view from Oslo that the European Union merited a Nobel Peace Prize. More below. The recent improvement in leading indicators: better news for profits and growth ahead? US and global purchasing manager surveys (PMI surveys) weakened during the summer, but have recently picked up modestly. Some argue that these changes could arrest the decline in earnings growth in sectors like technology and industrials. This seems plausible to us, and we believe it is more likely than another leg down in the global economy, which if it happened, would raise the risk of recession next year. PMI surveys are usually shown as an index level; in the two charts below, we show year on year changes to get a sense for the turns in the cycle. They tend to precede changes in earnings. Technology earnings and Global PMI survey Industrial earnings and Global PMI survey Percent change. YoY (both axes) Percent change, YoY (both axes) 80% 100% 80% 80% Global Technology 800/6 60% - Global Industrial 60% PMI EPS 60% PMI EPS 40% 40% 4- -4 40% - 4- 60% 40% 20% 20% 20% - 20% 0% 0% 0% 0% -20% -20% -20% -20% -40% -40% -40% -40% -60% 2004 2006 2008 2010 Source: Bloomberg. J.P. Morgan Securities LLC. 2012 2004 2006 2008 2010 Source: Bloomberg, J.P. Morgan Securities LW. 2012 Most leading indicators suggest that the world is stuck in a period of low but positive growth, rather than a period of deteriorating conditions. If so, the recent trend of downward revisions to earnings may come to an end as well, particularly if leading indicators keep improving. Last week, we discussed competing valuation models on US equities which describe them as being either very cheap or very expensive. We think the reality is somewhere in between, and that perceptions of value are more influenced by the lack of fixed income returns than at any time we can remember. This year's equity market gains already factor in an improvement in economic conditions, profits and politics. On the latter point, markets appear to assume that the US legislated fiscal consolidation ("fiscal cliff') will be renegotiated from 4.3% of GDP to 1.0%-1.5% of GDP. Our contacts indicate that this may be premature; we won't know for sure until the lame ducks are quacking. Positive turn in leading indicators may signal an end to Global and US manufacturing activity stabilizing falling earnings expectations Manufacturing PMI index, 50+=expansion $128 61 - $123 $118 $113 $108 $103 S&P 500 estimated earnings per share 032012e 2013 59 57 55 53 51 49 $98 47 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Source: FactSet. Data as of October 2012. 'Annualized EPS. Source: Institute for Supply Management, J.P. Morgan Securities LLC. I EFTA01071146 Eye on the Market I October 15, 2012 J.P.Morgan Topics of the week: the slight upturn in US leading indicators and the implications for profits; the magnitude of the US housing recovery; Europe's prize; and US energy independence How large a US housing recovery? Roger Altman, a former Treasury official and founder of Evercore Partners, wrote an article in the Financial Times arguing that the US housing recovery would boost the US economy. What caught our eye was the view that housing would contribute 1-2 percentage points to US GDP growth and spark a growth rebound above the Fed's 5-year forecast of 2.5%. To get started, here are some charts on things we agree with him on: the decline in measured and shadow inventories; an increase in pent-up demand due to the slowing of household formation relative to population growth; the rise in the affordability of housing compared to renting; and the increase in the number of banks reporting a rise in residential mortgage demand. We also agree that census data shows that population growth in the 55+ category (with the highest home ownership rates) is at a 70-year peak. "Shadow inventory" is steadily declining Million units 7 Historical Real estate owned (REO) 6 5 4 3 2 60+ days delinquent 0 2000 2002 2004 2006 2008 2010 2012 2014 Source: J.P. Morgan Securities Loan Performance, MBA. Data as of O2 2012 Pent-up demand has accumulated Pent-up dem and for housing, m illi0nS of units Projected 1.5 Where buying is cheaper than renting Percent of metropolitan statistical areas 60% S0% 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: JPMAM, Census Bureau. Demand for residential mortgages is improving %of banks reporting more (less) dem and for res. mortgages 80 60 40 40% 20 0 -20 20% -40 -60 -80 0% 100 2000 2002 2004 2006 2008 2010 2012 1991 1994 1997 2000 2003 2006 2009 2012 So urce:J.P. Morgan Securities LLC. AxioMetrics, CoreLogic FHLMC. Source: Federal Reserve Board. 30% 10% ‘1 However, we are having trouble making Altman's math work when it comes to the contribution to overall GDP growth. As shown in the first chart below, there are only a couple of times when housing contributes 1-2 percentage points to growth, the most notable being the post-war period of rapid household formation by returning war veterans. Even during the 2000's housing boom, it was only around half a percentage point. Part of why Altman's forecast may be difficult to hit is the decline in the share of housing in GDP, shown in the second chart below. Altman cites a Barclay's forecast that Case-Shiller home prices will reach their pm-crisis peak by 2015 (3s chart). Anything is possible, but given tighter credit standards (4ih chart), a recovery in prices will have to rely more on income growth than a rapid expansion in credit. This is highlighted by the divergence between reported home sales (rising) and the mortgage application index (still close to its lowest levels, no sign of a rebound). We appreciate the multiplier benefits that could be derived from a continued recovery in housing, but are keeping expectations in check for next year. Even if legislated fiscal tightening for 2013 is postponed, GDP growth substantially above 2.5% seems like a tall order. By the way, there are interesting opportunities in the rental markets for investors: in some regions, the gap between current rental yields and after-tax 30-year mortgage costs is the highest on record (since 1971). 2 EFTA01071147 Eye on the Market I October 15, 2012 J.P.Morgan Topics of the week: the slight upturn in US leading indicators and the implications for profits; the magnitude of the US housing recovery; Europe's prize; and US energy independence Housing rarely contributes 1-2 % points to GDP growth Residential investment contribution to real GDP growth. ppts 2.5 2.0 7- 1.5 Share of housing in GDP at lowest levels since pre-war era Residential investment. percent of GDP 8 0.5 6- 1.0 5- 1 1/ I •1.0 I -1.5 4 - 3 -2.0 0 1930 1940 1950 1960 1970 1980 1990 2000 2010 1930 1940 1950 1960 1970 1980 1990 2000 2010 Source:BEA. Source: BEA. Barclays home price forecast cited by Altman Higher FICO scores required for obtaining a new mortgage Index. 2006m 1=100 Average FICO score of mortgage originations 105 770 100 95 90 85 80 75 70 65 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Sou ce: Federal Housing FinanoeAgency.S8P.CoreLogic. CoreLogic 750 730 710 690 670 650 630 2002 2004 2006 2008 2010 2012 2000 Sou ce:J.P.MorganSecurtiesLLC. McDash Onina Data as of August. US energy independence within the next 10-15 years? Yes, it's possible, depending on how you define it More on this next week. but depending on your definition of energy independence, a combination of supply and demand factors has the potential to substantially reduce US oil imports. The chart shows our estimates of these factors. Reduced US oil import needs that can be sustained by neighboring countries may result in: (a) the era of US foreign policy being What US energy independence might look like US net crude oil imports, million barrels perday heavily dictated by energy security coming to an end. and (b) substantial growth, employment and 10 currency benefits from a shift to domestically 9 sourced production. We are not arguing that such 8 trends will bring down oil prices. since other 7 consumers (e.g., China) are likely to see continued 6 increases in demand. Next week, we will walk 5 through each segment of the chart in detail as part of 4 our annual energy outlook, along with a look at how 3 Europe and Japan are defining energy independence 2 quite differently. with much greater planned contributions from renewable energy (specifically, 0 offshore wind). Also, an update on the latest news on electric cars (which in 2012 was not very good). I I F-^i i 1 4 I I Oil Imported for refined product Displaced by Natural Gas Reduced consumption: CAFE and Auto Replacement Cycle Net increase in domestic exports Vehicles standards production CoUBrazIl Net Imports Net Imports Canada 2012 2025 Current US Projection imports Source:US Energy Information Ad ministration, J PMAM. 3 EFTA01071148 Eye on the Market I October 15, 2012 J.P.Morgan Topics of the week: the slight upturn in US leading indicators and the implications for profits; the magnitude of the US housing recovery; Europe's prize; and US energy independence The European Union, the latest winner of the Nobel Peace Prize Normally, peace prizes lay outside the realm of investment discussions. But in this case, politics and economics collide. The Nobel committee lauded the European Union for bringing peace to a continent at war. An understandable point of view, but it is this kind of thinking that elevates the Euro to a project that must be preserved at all costs. Such arguments have always puzzled me. By 1954, Germany had already become a stable, liberal, democratic society, one of the most amazing transformations in history given what preceded it ten years earlier. One can argue whether the Marshall Plan, in avoiding the reparations policies following WWI, paved the way for this or not. In any case, it seems indisputable that conditions for a lasting peace in Europe were already in place by 1954, a point of view explained by Stanford's James Sheehan in "Where have all the soldiers gone: The Transformation of Modern Europe". The notion that the Euro is needed to cement these gains appears to be more about the ambition of specific political movements in Europe/Brussels than anything else. Nevertheless, Europe soldiers on with its project, out of the belief that a single-currency monetary union must exist in order to reap the benefits of a common European consciousness. The irony of the Nobel Peace Prize for Europe is that as shown below, it comes at a time of rising social stress. There are of course those who believe that the Euro itself has contributed to these developments: it distorted the regional current accounts and encouraged consumption not funded by national income in the South, exaggerated the severity of the recession, and then prevented currency adjustments which mitigated Southern European recessions in the past. Europe's Nobel Peace Prize comes at a challenging titne for the region Election results of extremist right-wing parties in selected Ell member countries, national parliamentary elections Using the definition of extremism as applied by the Friedrich EbertFoundation in its 2011 analysis: see notes below. 35% Periods shown: 1980-1984, 1985-1989, 1990-1994, 1995-1999, 2000.2004. 2005-2009 and 2010-2012 30% 25% 20% 15% 10% 5% 0°/ Belgium Denmark France Greece Italy Norway Nether! Austria Switzer! Source:Using FES partydefinitions and electoral results for 1980-2009:our updates for 2010.2012. FES paper: 'Is Europe on the Right Path? Right-wing extremism and right-wing popuism in Europe'. Lan g enbacher an d Schellenberg. Friedrich Ebert Stinting (Friedrich Ebert Foundation). 2011. Established in 1925. the FES is thepolitical legacy of Friedrich Ebert. Germany's li rst d °mimetically elected President. and has offices in 90 countries worldwide. Measuring the social fabric in Europe through Google A poll of European citizenry, conducted by the EU: Searches, Index, Max Search Volume= 100 "Do you have trust in the European Union?" 90 60 80 Greece Depression 55 70 60 50 40 30 20 10 0 Catalonia Independence In 8 ra- 8 " 00000333 N N N N N N N N von N. CO Oa.- CV OOOOOO.- OOOOOOOOO CV CV C•INC•INCMCN1 Source: Go ogle Trends. Spain Riots 0 CD CD CD CD CD 0 0 ;13 cm cm cm cm cm cm cm cm C4 50 45 40 35 30 2004 2005 2006 2007 2008 2009 2010 2011 Sou ce: 'Public Opinion in the European Union", Standard Eurobarometer 77. Spring 2012. 4 EFTA01071149 Eye on the Market I October 15, 2012 J.P.Morgan Topics of the week: the slight upturn in US leading indicators and the implications for profits: the magnitude of the US housing recovery; Europe's prize; and US energy independence An investments perspective: the improvement in European credit and equity markets has been substantial in recent weeks, a reaction to the ECB plan to effectively prevent any sovereign or bank defaults by printing money and monetizing government debt. However, in the absence of a full fiscal transfer union funded by Germany, prices for equity, credit and real estate in Europe need to be low enough to compensate for the risk that growth does not return soon enough. Case in point: we didn't start looking at European equities as being interesting again until earlier this year, when they reached a 40-year low in terms of relative valuation vs US equities (see composite price- dividend, price-earnings and price-book chart). After the recent rally, this gap has narrowed, but not by very much. Michael Cembalest J.P. Morgan Asset Management European equity discount to US: as bad as it gets? Com posite premiiinkliscoirit using PIE, P/8 and P/Dividend 10% 0% •10% - -30% 1975 1980 1985 1990 1995 2000 2005 2010 Source: MSC I. J.P. Morgan Securities LLC. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do nor provide tax advice. 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